Gordon Campbell: Risk Free Tax!

December 9th, 2009

On current indications the Buckle Tax review will provide the final draft of their recommendations to the government just before Christmas – to enable it to digest the content – and then release the document to the public during the third week of January.

While speculation about the report’s likely findings have focused on a capital gains tax or a land tax levied on the unimproved value of all land, very little attention has been paid to a more politically palatable option – a Risk Free Return Method (RFRM) targeted only at the property sector.

Before trying to explain the RFRM, it is worth noting that we have seen it before, as a recommendation by the McLeod Committee Tax review in 2001. Back then, the suggestion was that it should be applied across all forms of investment. This time only the residential rental property sector seems to be in the firing line, for now at least.

Briefly… under the RFRM, a benchmark rate of tax is chosen – as if the actual investment was risk free. (The McLeod Committee recommended that the rate for government bonds be chosen.) If the investment incurs losses greater than the risk-free rate, these cannot be written off against the RFRM. If the investment is high performance, the investor wins, since they are taxed at the RPFM rate, regardless. Compliance is simple, and is levied on the net equity that the taxpayer has in the property, not on its total value. The government gains more certainty about its likely revenue, in that they get a fixed revenue flow, regardless of how the investment fares.

Geoff Nightingale is a tax partner at PricewaterhouseCoopers and a member of the Buckle working group. He explains how the RFRM would work, in contrast to the current tax rules situation. “ If you started say with a $200,000 house and it had a $100,000 mortgage, the risk free rate of return would only be applied to the net equity of $100K. So the method would say we’ll forget what interest you pay, what depreciation you pay, what repairs and maintenance you carry out and what rental you charge.” The officials at IRD, he adds., have done their RFRM modeling on the basis of a [rather high] rate of 6%. So 6% of 100k would give you $6,000 of gross income and that would be taxed at whatever your marginal rate is…So if your marginal rate was 30 % you would pay $1800 of tax on that.”
So to be clear…would the RFRM be levied in addition to the depreciation rules that we currently have, or would it replace them ? “It would replace them, “ Nightingale says. “If this method were adopted it would be the only way in which a rental property was taxed. So it would have an advantage of simplicity …But it would probably mean that that for everybody except the negatively geared people, there would be some tax to pay..”

Yet presumably, it offers the advantage of making loss-making investment less attractive – in that it removes the ability for them to be written off against income ? “Yes. It takes it away.” Nightingale outlines the kind of tax situation that has triggered the Buckle working group’s concern. “The classic issue [at the moment] is that you’ve got a wage and salary earner…sitting with their own home at $500,000 and its debt free, and they go and borrow $500,000 and buy a $500,000 rental property.”

In this scenario, Nightingale explains, the wage and salary earner’s total gearing now is only 50% since it is $500,000 against a million dollars of assets [even though] all of the debt is loaded up against the rental property, which is 100 % geared. Now, lets say the rental property has a 6% rental yield, and thy guy is paying 6% interest, and another 2% on repairs, maintenance, insurance, and a further 2% of depreciation. It is that extra 4% that gets thrown up as a loss on the rental property, and that goes across and gets deducted, against his wage and salary income.” That, Nightingale says, is what currently happens.

Under the RFRM method though, the interest deprecation/expenses would be ignored. In this example, because the guy is 100% geared against the rental property there would be no RFRM tax to pay, since the RFRM is levied only against the net equity. “ But what would be turned off in his case would be the offsetting losses against his PAYE income…Funds that he’s previously been getting, would be turned off.”On ideological grounds as well, the RFRM could, (or should) be quite attractive to a centre-right government. After all, doesn’t the current taxation system mean that the government is left holding a share in the risks associated with private investment – if only by dint of the tax credits that can accrue ?

“Yes, you’re absolutely right.” Nightingale replies. “ In fact, it’s a one way bet. Because if [the investment] pays off big-time. then you get a capital gain on the sale. And the government doesn’t get a look at that. But yes, there is a level of risk sharing involved, and an underwriting of the cash loss…” Nine years ago, the RPFM solution that the McLeod Committee was advocating it across a wide swathe of business investment. This could have been dangerous for government revenues, and for the economy.

It would for instance, have rewarded safe, blue ribbon investment with a lower tax rate ( and thus for the wealthy, could have served as a handy substitute for either a corporate tax cut or a top income tax rate cut. As well as being regressive, it would have also penalized the sort of venture capital innovations that do carry genuine risks, and offer genuine rewards to the economy and to society, since those losses could no longer be written off, under a widely applied RFRM. Not surprisingly, the Clarek-led government didn’t buy the idea.

Those kind of possible impacts, Nightingale replies, is why the Buckle working party has kept its own version of the RFRM focussed very tightly indeed. “The working group has only looked at using the RFRM on the rental property market. We haven’t considered and I don’t think we will consider, expanding it. The hierarchy in the way we thought about it was : you start with a capital gains tax on a broad basis across all kinds of assets, apart from perhaps owner occupied housing. And you say what are the pros and cons of doing that ? ‘

‘And if you weren’t to do that, you might look at something like a land tax…If you decided that was too hard, or not politically tenable then – essentially as a third order [option] – you might fire at the rental property market which unconditionally, is not properly taxed at the moment. The RFRM is that rifle shot. You might sometime [later] consider expanding that to other classes of assets, but its not being considered as a model to tax business activity [in general.]….We have simply considered it as a rifle shot into the residential rental property market. Because we do have a consensus in the working group that this is a sector that has a tax problem. It is not being properly taxed.”

With any tax change, there is always a potential for collateral damage. Can Nightingale foresee any virtuous casualties of an RFRM levied on residential rental property investment ? “I wouldn’t have thought so, but we’ve done no work on that. All the data that we’ve looked at has been in aggregate for the sector.” By and large, Nightingale estimates somewhere around 5% would be ‘ not miles away’ from what the net rental stream would be for landlords, if the properties were being rented properly.

In 2001, the McLeod Committee had fixed the RFRM at the relatively safe ‘
risk free’ level as government bonds. Nowadays, wouldn’t any RFRM level need to be something of a sliding rate, sensitive to a range of externals ? “I agree,” Nightingale says. “I think we would have to adjust that number from time to time..Because it is designed to get at the risk free returns. So by definition, it must move around.” To ensure certainty and ease of compliance though, a degree of certainty – perhaps an RFRM rate reviewed every two years – would probably be required.

Finally, the IRD’s choice of a 6% rate in its modeling seems to have been arbitrary, and optimistically based on the direction in which the economy seems to be headed. “ I don’t think there’s any science behind it. That was the figure modelled, on the basis that if any reform came in, it would be next year, or the year after…and that will be a reflection of where we will be, once the economy starts to recover.,”

In the weeks and months ahead, the RFRM will doubtless receive a makeover, before being readied for public consumption – but increasingly, it looks more politically viable than either a capital gains tax, or a land tax.